The World Economic Outlook, April 2003: A review of the IMF’s assessment on relation between economic growth and institutions Ranja Sengupta

The World Economic Outlook, brought out by the IMF in April 2003, provides detailed chapters on many issues – on ‘Why Bubbles Burst?’, ‘Unemployment and Labor Market Institutions: Why Reforms Pay Off?’,  and on ‘Growth and Institutions’. This review intends to focus on the last of these – firstly, because it is a crucial and potent question and has severe repercussions on the future of developing economies, and secondly, because it raises issues more interesting and perplexing than the IMF would have us believe.

The overall conclusion of the chapter on ‘Growth and Institutions’ is that institutions play a major role in determining income per capita, economic growth and growth volatility across countries. And all the variables used by the report to measure institutions support this contention. In addition, the report finds that across the different regions of developing countries, per capita income and institutional quality rise in tandem. This pattern is not so consistent in the case of differences in growth rates and growth volatility. However, the question of causality remains much more tricky, as is admitted by the report.  The analysis is definitely very detailed and has also set itself in context within the literature. Some interesting omissions, of course, are present.

As the explanatory variables, the report introduces the concept of ‘perceptions and assessments’ of public institutions. It uses three measures of institutions. To quote, ‘these indicate, first, the quality of governance, including the degree of corruption, political rights, public sector efficiency, and regulatory burdens; second, the extent of legal protection of private property and how well such laws are enforced; and third, the level of institutional and other limits placed on political leaders’ (page 3, WEO April, 2003).

The perceptions approach has been used on the grounds that, ‘perceptions of the political, economic, and policy climate embodied in the institutional measures are likely to be of key importance in shaping overall conditions for investment and growth. Given the mobility of international capital, for example, such assessments may play a major role in determining a country’s ability to attract and retain investment inflows’ (page 3, WEO April, 2003). The role of governance has been treated as a key institutional variable. Its definition, boasts the report, is much wider and covers not just the extent of corruption as is sometimes seen in the literature. Recent literature has however, included many of these factors. The exact indicators have actually been used from other studies.

The line of enquiry is not new, nor are the conclusions reached. For quite some time now, the role of institutions in determining economic growth and incomes has been a hot topic for debate.  Finding its roots in the writing of Douglas North, a historical account of the issue is to be found in David (1994). Many empirical analyses are to be found in the literature e.g. Easterly and Levine (1997), Barro (1991), Knack (1996), Knack and Keefer (1995). The recent debate has concentrated on a few major views.  The first, forwarded among others by Jeffrey Sachs, John Gallup, Andrew Mellinger and Jared Diamond, is that geographical and historical factors like climate, soil fertility, location, climatic environment and natural resource endowments play the determining role in deciding the level of economic development.  This view underplays the role of institutions in such determination.

A second view, proposed among others in the works of Acemoglu, Johnson, and Robinson (2001, 2002), Engerman and Sokoloff (1997, 2002) and Rodrik, Subramanian, and Trebbi (2002), is that institutions subsume the effects of historical and geographical factors and thereby play the decisive role in determining the path of economic development and growth. For example, for all ex-colonies, the institutional framework will be shaped, at least in part, by the history of its colonization – its nature and extent. That is why, this line of argument suggests, European established settler-colonies like the US, New Zealand or Australia have well-established institutions that support property rights, enforce the rule of law, and hence support investment and growth. This line of opinion holds institutions as the key determinant of economic well-being.

A major branch of empirical research in this area concentrates on the effectiveness of the particular forms of institutions in determining the path of development (see for example, Dani Rodrik, 2000). While some have found financial institutions to be the driving factor, many others point towards political institutions like the role and the stability of the government, democratic elements within the political system and the effect of corruption. The role of the state comes in for a major critical analysis here. Accusations of ‘crony capitalism’ or corrupt governmental and other machinery (like banking institutions) fostered by the state have been regularly hurled by the Washington Consensus to explain the Asian collapse. This opens up questions as to which forms of institutions should be taken to be the pivotal ones, and whether the role of one form comes into conflict with that of another.

While it is undeniable that institutions have a major role to play in the development of a country, a crucial problem remains with specifics. The first is the choice of institutional variables, from which the study is obviously suffering. Secondly, choosing the exact quantitative or qualitative measure poses another problem. The need to distinguish between descriptive measures such as absence or presence of a particular type of institution, and the quality or performance of that institution is very important. The third problem is of data and methodology. This has also affected the study but to this we would come later. The fourth is the technical problem of using reduced form growth equations as opposed to structural growth equations, which much of the cross sectional studies have actually done. Fifth, institutional variables may be endogenous and not exogenous which would cause serious problems for an econometric analysis. This has been pointed out in the report but not taken care of. (for a reading of the type of problems that may arise with such studies, see Aron, 2000)

Right at the beginning, the WEO’s use of the concept of ‘perceptions and assessments’ introduce some arbitrariness into the measures of institutional quality used by the study and raises some doubts regarding the results. Though it claims to have used aggregates of over 300 indicators including ratings by country experts and survey results, the arbitrariness remains as is admitted by the report in the next line itself (Footnote no: 32, page 26, chapter 3, WEO, April, 2003). Surveys are very often biased and unfortunately, so can be experts’ opinions.

The fact is that no measure can quantify institutional qualities easily. Measures of the quality of institutions that affect economic exchange are suspect themselves. Clubbing various measures are also problematic. The literature on economic growth typically has classified and treated the proxies collectively as “sociopolitical measures.” This practice has tended to obscure the different channels through which institutions operate and has impoverished the interpretation of the role of institutions in growth. This is a serious flaw in analysing developing countries, especially since where ‘weak’ institutions are implicated in low growth. The IMF report suffers specially from this deficiency.

In addition, the IMF is completely preoccupied with variables with respect to government inefficiency and corruption, as well as political freedom. In fact the ‘quality of governance’ variable, includes as a major factor ‘regulatory burden’ which is a measure of the ‘absence of government control on goods market, banking system and international trade’. The measure therefore places undue emphasis on the so-called freedom of the country from government controls.

This emphasis on political powers of the government is deliberate. Positive association with growth and income levels then enables the IMF to grossly interfere with domestic political systems and workings of the government, and force the state to withdraw in the political as well as the economic sphere. And this is a necessity for the IMF, not for improving the lot of the developing countries, but to establish the dominance of private finance capital and multinational giants that it protects. This is the same task that is being undertaken by US military control of ‘rogue forces’ like the Taliban and Saddam Hussain in Afghanistan and Iraq.

At the same time, there seems to be an absence of most other types of indicators considered in the literature. To name just a few of those mentioned in the literature, indicators of business risk, social capital, local government performance, ethnic and racial tensions, social development and capability (including literacy, social mobility, size of urban classes and crude fertility rate), are all absent from the analysis (for a detailed discussion, see Aron (2000)).

In particular, ‘economic institutions’ in the form of banking and financial institutions are glaringly from the analysis. While these are not taken to be typical parts of the Anglo-Saxon system of capitalism, these are very much a part of ‘Continental capitalism’ which is based on the prominent role of banks in corporate finance and control. Many developing countries in fact fit this model of capitalism better than the Anglo-Saxon one which has obviously been the basis and the limitation of the WEO. In fact, there is a pretty large literature that discusses the role of banking institutions in determining the path of economic growth and development, especially in transition economies (for a comprehensive discussion, See Cernat, 2002). But perhaps this is more than an oversight or an inability to recognize forms of capitalism other than the dominant one.  It is more likely a denial of the powers of domestic banking and financial institutions that have been systematically weakened by the financial liberalization policies pushed by the IMF itself.  That would conveniently fall into place with the rise to dominance of the US Central bank as the single powerful financial institution in the world.

The ‘role of governance’ factor is very strongly related to growth, income levels and growth volatility, finds the report.  Judging by its definition, the value of this variable should be high for a democratic country, but cases of South Korea and China prove to be strong examples to the contrary. In fact, China does not even possess well-defined property rights, which is in fact the second institutional variable that the report considers. Nor does it possess the third, namely, institutional freedom of its political leaders. There are many other examples that defy this result. Even countries like Saudi Arabia, which has had a history of a government ruling with American military support, has a high income just because of its oil. Here, the factor of geographical or historical endowments would turn out to be more important.

A very important question arises when we come to the discussion on the role of policies viz.a.viz institutions. The policy variables include indicators involving inflation, trade openness, exchange rate over-valuation, government size, financial development and capital account openness. The report finds that the effect of policies (mainly involving trade openness, stronger competition and higher transparency) on per capita incomes across countries becomes insignificant when institutions are accounted for. The latter turns out to be the determining and significant variable. Only in two cases are the policy variables significant. One is where the financial development variable is found to have a significant impact on growth. The other is where exchange rate overvaluation is found to increase volatility. Similar results have also been found by many other studies, notably by Rodrik (2002).

Now, this turns out to be rather an embarrassment for the IMF-World Bank since they have relentlessly advocated policies of macro economic management and openness to trade as key forces for economic development and higher incomes. World Bank economists like David Dollar and Art Kraay have churned out paper after paper to prove that this is so. Works of J. Barro (1997), X. Sala-i-Martin (2002), have also publicized on a mass scale, similar findings. Of course, these did not take into account institutional factors as such but much of the later IMF justification of its policies viz.a.viz growth, poverty and income inequality have depended heavily on these results.

Caught in this predicament, the Report has desperately tried to save the situation by pointing out, how this can be explained (page 10,16, Chapter 3, WEO, April 2003). Many explanations are offered. First, last forty years of policies (captured in the measure used) cannot properly reflect the impact on present incomes, which may be a result of a period of policies much longer than that. Second, policies cannot be implemented properly and their effects on growth are weak unless proper institutions are in place (page 10, Chapter 3, WEO, April, 1993). Third, the directions of causality between institutions and policies are not clearly known and works, in most cases, in both directions (page 7, Chapter 3, WEO, April, 1993). Fourth, policies are part of the institutions themselves and may be correlated heavily with the institutional variables which would render them insignificant in a regression exercise. Fifth, Statistical and econometric analysis based only on cross sectional data (used by the study) that catches long term effects is unable to effectively capture the impact of policies which can change very rapidly. The fourth and the fifth explanations in particular, however show that there are major problems with this kind of an analysis. In this case, we cannot take any co-efficient at its face value.

The result viz.a.viz policies certainly raise another question. Policies of increased financial liberalization, or capital account openness (as the specific variable used by the report), have led to disastrous results in many economies, notably those in many countries in Latin America, Asia, and in Turkey and Russia. The main reason has been the volatility in short-term capital flows. It has been admitted as much by IMF and World Bank officials – for example, by the Economic Counselor and Director of Research of the IMF, Michael Mussa (2000)(see also Global Development Finance, 2001, World Bank, Chapter 3). Shouldn’t the results found by the WEO, if tested correctly, have shown a negative effect of financial openness on growth and, or at least a positive one on growth volatility?

In the concluding section to the discussion on institutions and policies, the Report ironically points to the weaknesses of its own methodology. To quote, ‘the “bottom line” from these findings is not that policies are unimportant, but that our econometric framework (which is constrained, in particular, by the limited time series data on institutions) is not well suited to uncovering a relationship between policies and growth that may well be revealed through time’ (page 17, Chapter 3, WEO, April, 2003).

If we are to believe them, we cannot take any of the conclusions seriously.

Readings:

Acemoglu, Daron, Simon Johnson, and James A.Robinson, (2001): ‘The Colonial Origins of Comparative Development: An Empirical Investigation,’ American Economic Review, Vol. 91 (December), pp. 1369–401.

Aron, J. (2000): ‘Growth and Institutions: A Review of the Evidence’, World Bank Research Observer 15(1): 99-135.

Barro, R. J. (1991): ‘Economic Growth in a Cross Section of Countries’, Quarterly Journal of Economics 106(2): 407-43.

Barro, R. J. (1997): ‘Determinants of Economic Growth: A Cross-Country Empirical Study’, Cambridge, MIT Press.

 Cernat L. (2002): ‘Institutions and Economic Growth: Which Model of Capitalism for Central and Eastern Europe?’, Journal for Institutional Innovation, Development and Transition, Vol. 6

 David, P. (1994): ‘Why Are Institutions the ‘Carriers of History’? Path Dependence and the Evolution of Conventions, Organizations, and Institutions’, Structural Change and Economic Dynamics, 5(2): 205-20.

Diamond, Jared. (1997): ‘Guns, Germs, and Steel: The Fates of Human Societies’ (New York: W.W. Norton).

Easterly, William, and Ross Levine. (1997): ‘Africa’s Growth Tragedy: Policies and Ethnic Divisions.’ Quarterly Journal of Economics 112(4, November): 1203–50.

 Engerman, Stanley L. and Kenneth L. Sokoloff (1997): ‘Factor Endowments, Institutions, and Differential Paths of Growth Among New World Economies: A View from Economic Historians of the United States,’ in How Latin America Fell Behind, (ed.) by Stephen Haber (Stanford, California: Stanford University Press), pp. 260–304.

——— (2002): ‘Factor Endowments, Inequality, and Paths of Development among New World Economies,’ NBER Working Paper No. 9259

Gallup, John L., Jeffrey Sachs, and Andrew D. Mellinger (1998): ‘Geography and Economic Development,’ NBER Working Paper No. 6849 (Cambridge, Massachusetts: National Bureau of Economic Research).

Knack, S. (1996): ‘Institutions and the Convergence Hypothesis: The Cross-Country Evidence’, Public Choice 87(3-4):207-28.

Knack, S and P. Keefer (1995): ‘Institutions and Economic Performance: Cross-Country Tests Using Alternative Institutional Measures’ Economics and Politics 7(3):207-27.

Mussa Michael (2000): ‘Factors Driving Global Economic Integration’, paper presented in Jackson Hole, Wyoming, at a symposium sponsored by the Federal Reserve Bank of Kansas City on ‘Global Opportunities and Challenges’, August 25.

North, Douglass. (1990): ‘Institutions, Institutional Change, and Economic Performance’, New York: Cambridge University Press

Rodrik Dani, Arvind Subramanian and Francesco Trebbi (2002): Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development, NBER Paper no. W9305

Rodrik Dani (2000): Institutions for High-Quality Growth: What They are and How to Acquire Them, NBER paper no. W7540

Sala-i-Martin, X. (2002): The Disturbing “Rise” of Global Income Inequality, Discussion Paper, Department of Economics, Columbia University